Thursday 18 October 2012

Buffett believes it is foolish to use short-term prices to judge a company's success. What happens to the stock price in the short run is inconsequential.

If adapting Buffett's investment strategy required only a change in perspective, then probably more investors would become proponents.  Unfortunately, applying Buffett's approach requires changing not only perspective but also changing how performance is evaluated and communicated.

The traditional yardstick for measuring performance is price change:  the difference between the purchase price of the stock and the market price of the stock.  In the long run, the price of a stock should approximate the change in value of the business.  However, in the short run, prices can gyrate widely above and below a company's value, dependent on factors other than the progress of the business.  The problem remains that most investors use short-term changes to gauge the success or failure of their investment approach.  However, these short-term price changes often have little to do with the changing economic value of the business and much to do with anticipating the behaviour of other investors.

Buffett believes it is foolish to use short-term prices to judge a company's success.  Instead, he lets his companies report their value to him, by their economic progress.  Once a year, he checks several variables:


  • Return on beginning shareholder's equity
  • Change in operating margins, debt levels, and capital expenditure needs.
  • The company's cash generating ability.



If these economic measurements are improving, he knows the share price, over the long term, should reflect this.  What happens to the stock price in the short run is inconsequential.

The difficulty of using economic measurements as yardsticks for success is that communicating performance in this manner is not customary.  Clients and investment professionals alike are programmed to follow prices.  The stock market reports price change daily.  The client's account statement reflects price change monthly and the investment professional, using price change, is measured quarterly. 

The answer to this dilemma may lie in employing Buffett's concept of "look-through" earnings.  If investor use look-through earnings to evaluate their portfolio's performance, perhaps the irrational behaviour of solely chasing price might be tempered.

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